A Bullish Market Metric Points to Tech Stocks

by Carla FriedMay 15, 2013

The 6% earnings yield for S&P 500 stocks is nearly 3x the yield of a 10-Year Treasury note. That’s well above the historic norm of 1.6x dating back to the 1940s. Bull leaners take note: S&P Capital IQ found that when the relative valuation is at least 2x, the S&P 500 has posted an average 12% gain over the ensuing 12 months. And right now the tech sector is teeming with earnings yield standouts, including Apple (AAPL), Cisco (CSCO) and Intel (INTC). The sector’s 7.1% average earnings yield is nearly four times the 10-year T note.

Granted, those three aren’t exactly beloved stocks at the moment. Nor are other tech earnings-yield standouts including Xerox (XRX) and Western Digital (WDC). If you want to pay up for momentum, this isn’t your sector. But if you’re looking to rotate into a less pricey sector that has a compelling underlying valuation story -- starting with earnings yield -- tech is where you want to focus.

While earnings yield, which divides trailing 12-month EPS by a stock’s current price (mirror image of PE ratio), makes a strong case for the relative value of stocks over bonds, it’s crucial to factor in the impact of Federal Reserve easing policy. The gap between earnings yield and the 10-year Treasury note would be appreciably smaller if not for the Fed’s rate suppression. As this chart shows, while the S&P 500’s earnings yield has been on the rise, the bigger factor in terms of relative value is the precipitous drop in the 10 year Treasury yield.

Using a more normal 4% yield for the Treasury note would put the S&P 500 earnings yield in the vicinity of 1.5x the Treasury yield. And at that level S&P Capital IQ notes average 12 month returns have averaged 5.4%, not the near 12% if you are working off of a valuation spread of at least 2.0.

But you don’t have to buy the S&P 500 – you can look for individual stocks with compelling earnings yield stories.

Using the YCharts Stock Screener turned up a handful of tech companies with earnings yield that would be at least double a normal 10-year Treasury yield. To sift out companies that are growing earnings but not revenue, the screen set a fairly low bar of revenue and EBITDA growth over the past five years of at least 5%. Then to drill down on companies that are generating far more earnings than are needed to run the company another filter required a free cash flow yield of at least 5%.

Western Digital, Xerox and Apple top the screen when ranking by both earnings yield and cash flow yield. (Just click on the column header to sort any metric ascending or descending order.) Befitting their out-of-favor status all three trade at forward PE ratios at least 30% below the market.

At the recent Berkshire Hathaway (BRK.B) annual meeting, Charlie Munger mused about the fact that a company like Coca-Cola (KO) has a more knowable future than an Apple. No arguing with that; global demand for Coke has an uncanny stickiness, while technology tastes can be more fickle. Still, unless you think Apple is going the way of the dinosaur, this chart shows a steep widening in the relative valuation of the two.

That doesn’t suggest Coca Cola is wildly overvalued (YCharts estimates it is about 8% or so above its historic multiples) rather that Apple, rated Attractive by YCharts proprietary analysis is undervalued. For the record, Coke’s earnings yield is 4.5%, about half that of Apple.

Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine. She can be reached at editor@ycharts.com.